Chapter-5

Income Inequality, Poverty and Development

(Interconnections)

By: Shambel Alemye

Assosa university (ASU)
 5.1. Income Inequality
• It is defined as the disproportionate distribution of total national
income among households.
Approaches to measuring income inequality
• Two principal measures of income distribution
1. The personal (size) distribution of income
 Graphical representation of inequality
o Lorenz curve
 Ratios
o Decile and percentile dispersion ratio
The Palma ratio
20/20 ratio
 Indices
o Gini Coefficient (Gini index)
2. The functional (distributive factor share) distribution of income
1. The personal or size distribution of income
‫ ٭‬Personal distribution of income (size distribution of
income):-The distribution of income according to size class of
persons.
• For example, the share of total income accruing to the poorest
specific percentage or the richest specific percentage of a
population without regard to the sources of that income.
• The personal or size distribution of income is the measure
most commonly used by economists.
• If Ms. X and Mr. Y both receive the same personal income, they
are classified together irrespective of the fact that Ms. X may
work 15 hours a day as a doctor while Mr. Y doesn’t work at all
but simply collects interest on his inheritance.
Lecture note: Poverty and development Class: MSc. In development economics

1. Graphical representation of inequality-Lorenz curve

• On the horizontal axis is the cumulative number of income recipients ranked from the poorest
to the richest individual or household. The vertical axis displays the cumulative percentage of
total income. The Lorenz curve reveals the percentage of income owned by x percent of the
population. •
• The percentage of income received is exactly equal
to the percentage of income recipient
• For example, the point halfway along the length of
the diagonal represents 50% of the income being
distributed to exactly 50% of the population.
• LC- shows the actual quantitative relationship
between the percentage of income recipients and
the percentage of the total income they receive
• The more the lorenz line curves away from the
diagonal (line of perfect equality), the greater the
degree of inequality represented.
• Perfect inequality a situation in which one person
receives all of the national income while everybody
else receives nothing.

© Shambel Alemye (MSc.) Assosa university, Economics Department

Lecture note: Poverty and development Class: MSc. In development economics

2. Ratios-Decile Dispersion Ratio

• It is a simple and popular measure of inequality
• It presents the ratio of the average consumption (or income) of the richest
10 percent of the population to the average consumption (or income) of the
poorest 10 percent.
• This ratio can also be calculated for other percentiles (for instance, dividing
the average consumption of the richest 5 percent, by that of the poorest 5
percent).
• The decile dispersion ratio is readily interpretable, by expressing the income
of the top 10 percent (the “rich”) as a multiple of that of those in the poorest
decile (the “poor”).
Palma ratio
• It is the ratio of national income shares of the top 10 per cent of households
to the bottom 40 per cent. It is based on economist José Gabriel Palma’s.
20/20 ratio
• It compares the ratio of the average income of the richest 20 percent of the
population to the average income of the poorest 20 percent of the
population. Used by the United Nations Development Programme Human
Development Report (called “income quintile ratio”).

© Shambel Alemye (MSc.) Assosa university, Economics Department

Lecture note: Poverty and development Class: MSc. In development economics

Example

© Shambel Alemye (MSc.) Assosa university, Economics Department

Lecture note: Poverty and development Class: MSc. In development economics
3. Indices-Gini Coefficient of Inequality
• It is the most widely cited measure of inequality; it measures the extent to which
the distribution within an economy deviates from a perfectly equal distribution.
The index is computed as the ratio of the area between the two curves (Lorenz
curve and 45-degree line) to the area beneath the 45-degree line.
• A higher Gini coefficient represents a more unequal distribution. If Gini
coefficient becomes 0, which means perfect equality, whereas if the Gini
coefficient becomes 1, which means complete inequality.

© Shambel Alemye (MSc.) Assosa university, Economics Department

Lecture note: Poverty and development Class: MSc. In development economics
Example
i xi n X 2i 2i-n-1 (2i-n-1)*xi
1 10 10 33 2 -9 -90
2 15 10 33 4 -7 -105
3 20 10 33 6 -5 -100
4 25 10 33 8 -3 -75 G=1000/330*10
5 40 10 33 10 -1 -40 = 0.30303
6 20 10 33 12 1 20
7 30 10 33 14 3 90
8 35 10 33 16 5 175
9 45 10 33 18 7 315
10 90 10 33 20 9 810
330 1000

© Shambel Alemye (MSc.) Assosa university, Economics Department

 2. Functional Distributions
• It is defined as the distribution of income to factors of production
without regard to the ownership of the factors.
• Attempts to explain the share of total national income that each
of the factors of production (land, labor, and capital) receives.
• Instead of looking at individuals as separate entities, the theory of
functional income distribution inquires into the percentage that
labor receives as a whole and compares this with the percentages
of total income distributed in the form of rent, interest, and profit.
• Attempts to explain the income of a factor of production by the
contribution that this factor makes to production. Supply and
demand curves are assumed to determine the unit prices of each
productive factor. When these unit prices are multiplied by
quantities employed on the assumption of efficient (minimum-
cost) factor utilization, we get a measure of the total payment to
each factor.
• The supply of and demand for labor are assumed to determine its
market wage. When this wage is then multiplied by the total level of
employment, we get a measure of total wage payments (total wage
bill).

• Total national represented by the area 0RELE.

• This will be distributed in two shares:
0WEELE going to workers in the form
of wages and WERE remaining as capitalist
profits (the return to owners of capital).
• Unfortunately, the relevance of the functional
theory is greatly diminished b/c it didn’t
consider-collective bargaining in labor, power
of monopolists and wealthy, landowners to
manipulate prices on capital, land, and output
to their own personal advantage.
5.2. Poverty
 Approaches To Measures Poverty

1. Income poverty or absolute poverty

measures

• Foster-greer-thorbecke (FGT) index

• Headcount and Headcount

index

• Total poverty gap (TPG)

• Square poverty gap (SPG)

2. Multidimensional Poverty Index

 Income poverty
• Absolut poverty measured by income- And it is defined as the situation of being
unable or only barely able to meet the subsistence essentials of food, clothing,
and shelter.
• Using the total number living below a specified minimum level of real income/an
international poverty line/anyone living on less than $1.25 a day in 2005 PPP
dollars) we can say she/he is in absolute poverty.
• But this is possible when information is available on a welfare measure, such as
income per capita for each household or individual.
• Foster-Greer-Thorbecke (FGT)
• All belong to the Foster-
o Headcount index Greer-Thorbecke (FGT) class
o Poverty gap index of poverty measures.
o Squared Poverty Gap Index
 1. Headcount and Headcount index
• Headcount index- the proportion of a country’s population living below
the poverty line.
• Headcount or H- is the number of people whose incomes fall below the
absolute poverty line, Yp.
• When the headcount is taken as a fraction of the total population, N, we
define the headcount index, H/N (also referred to as the “headcount
ratio”). It shows relative incidence.
• However, simply counting the number of people below an agreed-on
poverty line has serious limitations. Because it doesn't show the
seriousness of poverty problem.

• I(·) is an indicator function that takes on a

value of 1 if the bracketed expression is true,
and 0 otherwise.
• So if expenditure (yi) is less than the poverty
line(z), then I(·) equals 1 and the household
would be counted as poor.
Three weaknesses:
• First, the headcount index does not take the intensity of poverty into
account.

• Clearly, there is greater poverty in country A, but the headcount index does not
capture this.
• Second, the headcount index does not indicate how poor the poor are,
and hence does not change if people below the poverty line become
poorer.
• Third, the poverty estimates should be calculated for individuals, not
households.
• If 20 percent of households are poor, it may be that 25 percent of the
population is poor (if poor households are large) or
• 15 percent is poor (if poor households are small); the only relevant figures
for policy analysis are those for individuals.
 2. Poverty gap index (PGI)
• An obvious problem with the head-count • Even though in both country A and country
ratio is that it fails to capture the extent B, 50% of the population falls below the
to which same poverty line, the TPG in country A is
individual income (or expenditure) falls greater than in country B. Therefore, it take
below the poverty line.
more effort to eliminate poverty in country
• Therefore Economists attempt to A. The TPG—the extent to which the
calculate a total poverty gap (TPG) that incomes of the poor lie below the poverty
measures the total amount of income line—is found by
necessary to raise everyone who is
below the poverty line up to that line.
• TPG- shows the amount of money per day it
would take to bring every poor person in an
economy up to our defined minimum income
standards.
• POVERTY GAP INDEX: shows the
average income shortfall (AIS), can be
calculated as AIS =TPG/H. The AIS tells us
the average amount by which the income of a
poor person falls below the poverty line.
• Example:- More specifically, define the poverty gap (Gi) as the poverty line (z)
less actual income (yi) for poor individuals; the gap is considered to be zero for
everyone else.

• On average, the poor have an expenditure shortfall of 8% of the poverty line.

Note:-The per-capita cost of eliminating daily poverty is equal to PG*Z

• It is the minimum cost of eliminating poverty (relative to the poverty line),
because it shows how much would have to be transferred to the poor to bring
their incomes or expenditures up to the poverty line (as a proportion of the
poverty line).
Drawbacks
• Not captured the difference in severity of poverty-unaffected by
transfer.
 3. Squared Poverty Gap (Poverty Severity) Index
• To construct a measure of poverty that takes into account inequality
among the poor.
• Hence, by squaring the poverty gap index, the measure implicitly
puts more weight on observations that fall well below the poverty
line.
• Formally,
 • In general, form the Foster, Greer, And Thorbecke (1984),
which may be written as
Where,
o α is ‘poverty aversion’ parameter
o a measure of the sensitivity of the
index to poverty
o The larger α is, the greater the weight
placed on the very poorest people.

• The squared gap, which uses the square of the normalized gap for each poor
person.
• The squaring process emphasizes the larger gaps relative to the smaller gaps.
• It is sensitive to the prevalence of the poor, the extent to which their incomes
fall below the poverty line, and the distribution of their incomes or shortfalls.
 2. Multidimensional poverty measures
• Poor people themselves define their poverty much more broadly
than the traditional approach by including lack of education, health,
housing, empowerment, employment, personal security and more.
• No one indicator, such as income, is uniquely able to capture the
multiple aspects that contribute to poverty.
• For this reason, since 1997, Human Development Reports (HDRs)
have measured poverty in ways different than traditional income-
based measures.
• The Human Poverty Index (HPI) was the first such measure, which
was replaced by the Multidimensional Poverty Index (MPI) in
2010.
 Continued…
• The MPI is an index designed to measure acute poverty. Acute
poverty refers to:-
o It includes people living under conditions where they do not
reach the minimum internationally agreed standards in
indicators of basic functioning's, such as being well nourished,
being educated or drinking clean water.
o It refers to people living in both undernourished and do not
have clean drinking water, adequate sanitation or fuel.
• The MPI combines two key pieces of information to measure acute
poverty:
o The incidence of poverty, or the proportion of people (within a
given population) who experience multiple deprivations, and
o The intensity of their deprivation - the average proportion of
(weighted) deprivations they experience.
 Continued…

• This minimum level of satisfaction is

called a deprivation cut-off.
 Continued…

Methodology step-by-step
• Step 1: Defining the data source
• Mostly household survey
• Step 2: Choosing the unit of analysis
• MPI identifies an individual as deprived based on household
achievements so the unit of analysis is the household because
internationally comparable surveys do not have individual-level
information for all indicator
• Step 3: Choosing the dimensions and indicators
MPI uses ten indicators belonging to three dimensions
• Education-2 indicators
• Health-2 indicators
• Standard of living-6 indicators
Continued…
Continued…
Continued…
 Step 5:choosing the poverty cut-off/identify the poor/
• The deprivation score of each person is calculated by taking a
weighted sum of the number of deprivations, so that the deprivation
score for each person lies between 0 and 1.
• The score increases as the number of deprivations of the person
increases and reaches its maximum of 1 when the person is deprived
in all component indicators.
• A person, who is not deprived in any indicator, receives a score
equal to 0.
• Someone is considered poor if
his/her deprivation score is equal
or greater than the poverty cut-off
(i.e. 1/3 or 33%).

• Households with a deprivation score between 1/5 and 1/3 are

considered vulnerable to or at risk of becoming multidimensional
poor.
• For those whose deprivation score is below the poverty cut-off, even if it is non-zero,

• Note: If there are fewer than 10 indicators, suppose there is a country whose dataset is
missing one of the living standard indicators (i.e. no information was collected on that
variable). Thus, the total number of indicators is nine in this case. Then each of the four
health and education indicators receive a 1/6 weight but each of the standard of living
indicators receive a 1/15 weight (1/3 ÷ 5).
Continued…
• Interpretation of MPI: the percentage of deprivations poor people
experience, as a share of the possible deprivations that would be
experienced if all people were deprived in all dimensions.
Continued…
• This implies; they are deprived at least either a) all the indicators of a single
dimension or b) a combination across dimensions such as being in a household
with a malnourished person, no clean water, a dirt floor and un-improved
sanitation.

o poor people experiences 45% of deprivations as a share of the

possible deprivations that would be experienced if all people were
deprived in all dimensions.
• The MPI represents the share of the population that is
multidimensional poor adjusted by the intensity of the deprivation
suffered. This adjustment is necessary because if we only look at H
we merely know that 80 per cent of the population is poor. But are
they deprived in 100 per cent of all the considered deprivations? In
this society, they are not.
• The average poor person is deprived in 56 per cent of the weighted
indicators, so the intensity is 56 percent. These are called
“weighted” indicators, because to create the deprivation score ci
each deprivation is entered according to its relative weight.
• The 80 per cent figure is “adjusted” by the intensity of poverty. If
there was a society with 80 per cent poor people, and all of them
were deprived in all the indicators, then A would be 1, and thus the
MPI would equal H.
• Alternatively, if there was a society where 100 per cent of people
were poor, then the MPI would be equal to A.
 Continued…
• If everyone was deprived in all the considered indicators in a
society the MPI would be 100 per cent.
• If, the 80 percent of people who are poor were deprived in all the
considered indicators, the MPI would be 80 per cent.
• However, because they are on average deprived in 56 percent of the
weighted indicators, that society is deprived in 45 percent of the
total potential deprivations it could experience overall.
 Kuznets Inverted U-hypothesis
• Simon Kuznets suggested that in the early stages of economic growth, the
distribution of income will tend to worsen; only at later stages will it
improve.
• It is a graph reflecting the relationship between a country’s income per
capita and its inequality of income distribution.
• Early growth may, in accordance with the Lewis model, be concentrated
in the modern industrial sector, where employment is limited but wages
and productivity are high.
 Poverty Reduction and Economic Growth
• Are the reduction of poverty and the acceleration of growth in conflict? Or are they
complementary?
• Traditionally, a body of opinion held that rapid growth is bad for the poor because
they would be bypassed and marginalized by the structural changes of modern
growth.
• Beyond this, there had been considerable concern in policy circles that the public
expenditures required for the reduction of poverty would entail a reduction in the
rate of growth. E.g progressive taxation-redistribution of income/asset from rich to
poor-reduce saving.
• But the reality is poor's good in financial saving, spend additional income on
improved nutrition, education for their children, improvements in housing
conditions, and other expenditures (at poverty levels, investments higher than
consumption). There are at least five reasons why policies focused toward reducing
poverty levels need not lead to a slower rate of growth—and indeed could help to
accelerate growth.
• First, widespread poverty creates conditions in which the poor have no access to
credit, are unable to finance their children’s education, and, in the absence of
physical or monetary investment opportunities, have many children as a source of
old-age financial security.
• Second, the rich in many contemporary poor countries are generally
not noted for their frugality or for their desire to save and invest
substantial proportions of their incomes in the local economy.
• Third, the low incomes and low levels of living for the poor, which
are manifested in poor health, nutrition, and education, can lower
their economic productivity and thereby lead directly and indirectly
to a slower-growing economy.
• Fourth, raising the income levels of the poor will stimulate an
overall increase in the demand for locally produced necessity
products like food and clothing, whereas the rich tend to spend
more of their additional incomes on imported luxury goods.
• Fifth, a reduction of mass poverty can stimulate healthy economic
expansion by acting as a powerful material and psychological
incentive to widespread public participation in the development
process.
 Economic Characteristics of poverty groups
• We have argued that the magnitude of absolute poverty results from a
combination of low per capita incomes and highly unequal
distributions of that income.
• But, before we can formulate effective policies and programs to attack
poverty at its source, we need some specific knowledge of these high-
poverty groups and their economic characteristics.
Rural Poverty
• Perhaps the most valid generalizations about the poor are that they are
disproportionately located in rural areas, that they are primarily
engaged in agricultural and associated activities, that they are more
likely to be women and children than adult males, and that they are
often concentrated among minority ethnic groups and indigenous
peoples.
• So that in view of the disproportionate number of the very poor who
reside in rural areas, any policy designed to alleviate poverty must
necessarily be directed to a large extent toward rural development in
general and the agricultural sector in particular.
 Women and Poverty
• Women make up a substantial majority of the world’s poor.
• If we compared the lives of the inhabitants of the poorest
communities throughout the developing world, we would discover
that virtually everywhere women and children experience the
harshest deprivation.
• They are more likely to be poor and malnourished and less likely
to receive medical services, clean water, sanitation, and other
benefits.
• Lower earning capacity of women, and their limited control over
their spouses’
income all contribute to this disturbing phenomenon.
• In addition, women have less access to education, formal-sector
employment, social security, and government employment
programs.
• These facts combine to ensure that poor women’s financial
resources are meager and unstable relative to men’s.
 Policies Options for Poverty Reduction and enhance income
Distribution
• We can identify four broad areas of possible government policy
intervention, which correspond to the following four major elements in
the determination of a developing economy’s distribution of income.
1. Altering the functional distribution—the returns to labor, land, and
capital as determined by factor prices, utilization levels, and the
consequent shares of national income that accrue to the owners of each
factor. Removal of such factor-price distortions would therefore go a long
way toward combining more growth, efficiently generated, with higher
employment, less poverty, and greater equality.
2. Mitigating the size distribution through Increasing assets of the Poor
—the functional income distribution of an economy translated into a size
distribution by knowledge of how ownership and control over productive
assets and labor skills are concentrated and distributed throughout the
population. The distribution of these asset holdings and skill endowments
ultimately determines the distribution of personal income. E.g. Land
reform
3. Moderating (reducing) the size distribution at the upper levels
through progressive taxation of personal income and wealth.
Such taxation increases government revenues that decrease the
share of disposable income of the very rich—revenues that can,
with good policies, be invested in human capital and rural and
other lagging infrastructure needs, thereby promoting inclusive
growth.
4. Moderating (increasing) the size distribution at the lower
levels through public expenditures of tax revenues to raise the
incomes of the poor either directly (e.g., by conditional or
unconditional cash transfers) or indirectly (e.g., through public
employment creation such as local infrastructure's projects or the
provision of primary education and health care or like preschool
nutritional supplementation programs or other safety net
programs).
The end!!!
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